Abstract:

In our first essay, we investigate how the New York Stock Exchange (NYSE) specialists react to the changes in market variables while making participation decisions to the posted quotes by analyzing specialists' choices to undercut or add depth to the limit order book. We find that the primary factor that affects the participation strategy of the specialists in the current period is the changes in the best prices and depths on the limit order book. In addition, specialists participate to the posted quotes more for volatile or low volume stocks. The levels of specialists' participation in the posted quotes have predictive power over future stock returns. This predictive power is stronger for short-term returns.
In our second essay, we analyze trading strategies of the specialists conditional on their decisions to participate in the current posted quotes. We find that the specialists use limit order book asymmetry and cumulative order imbalance as two information sources about the true security value. If the relative size of the market order is high, specialists choose not to participate and let the market order trade with the limit order book. Consistent with the theoretical results in the previous literature, specialists trade more aggressively when the spread is large. We also find significant inventory effects. The specialists trade more aggressively, if the trade with the incoming market order restores their inventories.
Our third essay shows that there exist significant differences between the performances of &quot;individual&quot; specialists in terms of quotes, depths, spreads and execution costs. We find that, as the trading frequency increases, order processing costs increase for both the specialist firms and individual specialist portfolios, which is consistent with the hypothesis that profits from active stocks subsidize inactive stocks. We also show that individual NYSE specialists differ significantly in their participation strategies to the posted quotes and trades. This suggests that there are significant differences in the execution costs between specialists, because they use different strategies.